McKesson’s Promising Prognosis
In terms of annual revenue, McKesson («www.businessweek.com») is the No. 1 pharmaceutical distributor in the U.S., Canada, and Mexico, the largest health-care IT provider, and the largest distributor of medical-surgical products to physicians and extended care markets. We believe that by leveraging its leading position in these markets to enhance “one-stop shopping” and increase cross-selling, the health-care distribution giant will continue to penetrate its core customer markets and generate above-average revenue and earnings growth.
We think that McKesson will continue to post above-average revenue and earnings growth over the next three to five years, at least, on rising demand for drugs and health-care IT products, and services and cost controls. Given our view of the health-care distributor’s promising growth prospects and its compelling valuation, we have a 5-STARS (strong buy) recommendation on the shares.
Beginning in fiscal 2008 (ending March), McKesson will report its results in two segments. The McKesson Distribution Solutions segment will include what was previously reported as the company’s Pharmaceutical Solutions and Medical-Surgical Solutions units. The McKesson Technology Solutions segment will include the company’s Provider Technologies unit and its Payor business, which provides services and software products to payors (e.g., health insurers), employers, and government organizations to help manage the cost and quality of care. (Our earnings model utilizes pro forma fiscal 2006 and fiscal 2007 income statements reflecting the new segment breakdown, as provided by McKesson from a recent 8-K filing, but adjusted for nonrecurring items.)
The McKesson Distribution Solutions segment (98% of total revenues in fiscal 2007) is a leading distributor of branded and generic drugs, medical-surgical supplies and equipment, and health and beauty care products throughout North America. This business also provides medical management and specialty pharmaceutical solutions for biotech and pharmaceutical manufacturers as well as software and consulting and outsourcing services to pharmacies. Through McKesson’s investment in Parata Systems, it sells automated pharmaceutical dispensing systems for retail pharmacies. Overseas Opportunities
We expect revenues and operating margins to expand at the McKesson Distribution Solutions segment, fueled by the company’s concentration on the relatively faster-growing, higher-margin products and services in both pharmaceutical and medical-surgical distribution. In particular, segment revenues will benefit from the slew of new generic and specialty drugs that we foresee, as well as increasing enrollment in the Medicare Prescription Drug Program and higher penetration of Mexico and Canada. Margins should improve on cost controls and, in our view, generic drug volumes rising as a percentage of sales.
The McKesson Technology Solutions segment (2%) delivers enterprise-wide patient-care, clinical, financial, supply-chain, and strategic-management software solutions; pharmacy automation for hospitals; and connectivity, outsourcing, and other services, to health-care organizations in the U.S., Canada, the U.K., Ireland, France, the Netherlands, Australia, New Zealand, and Israel. Its customers include hospitals, physicians, home-care providers, retail pharmacies, and payors.
Revenues will grow at the McKesson Technology Solutions segment, propelled mainly by strong demand for its high-margin clinical software and medical imaging solutions. We also see impetus from federal government initiatives to convert all medical records to electronic form, hospitals’ efforts to cut medical errors, and providers’ and payors’ interest in improving operating efficiency and reducing administrative costs. Moreover, we expect the segment to enjoy healthy growth not only in the U.S., but also overseas, and view the strong demand for its products and services as sustainable through at least the next three to five years. Segment revenue and earnings should continue to grow faster than those of the company as a whole, by our analysis. Better Mix of Products
We look for total revenue growth of 7.3% in fiscal 2008, following fiscal 2007’s 6.9% increase, with top-line growth accelerating on a quarterly basis. Significant generic drug launches and continuing healthy increases in medical-surgical sales to the alternate site market are key parts of this growth. (McKesson defines the alternate site market as consisting of physician offices, surgery centers, occupational health, home care, and extended care, which are benefiting from the migration of care and procedures out of the hospital.) In addition, we see a boost in Technology Solutions sales, on both the Per-Se Technologies acquisition (see below) and strong organic growth.
We project company-wide operating margins to continue to widen gradually over the longer term, partly on an improving product mix and cost controls in Distribution Solutions. Key drivers in this improving performance are: increased sales of generics and private-label products; McKesson’s intention to increase international product sourcing and product development; the September, 2006, divestiture of the underperforming acute care medical-surgical distribution business; and an ongoing Six Sigma operating efficiency program.
Also, we look for the high-margin Technology Solutions segment to grow as a percentage of total revenue. For fiscal 2008 and fiscal 2009, we expect margins to benefit from synergies realized from the integration of Per-Se. We believe the segment’s operating margin would be even wider, if not for McKesson’s intention to increase R&D and sales and marketing spending, which we view as investments for long-term performance.
All told, we look for fiscal 2008 operating EPS to grow 17.5% to $3.35, and expect the March (or fourth) quarter to exhibit the strongest performance in fiscal 2008, partly owing to the timing of generics launches. In fiscal 2009, we see EPS of $3.85, representing growth of 15%.
